Introduction to

Options
B, K & M Chapters 20 & 21

End-of-chapter problems: 1-9,17,18,20,24,25; 1-10,12-15,17-20

 Types of Options
 American Call Option:
 Contract giving its owner the right to purchase a given
number of shares (100) of a specific security at the strike price
(X) at any time prior to maturity (T)
 A call is not an obligation to buy 100 shares at $X per share.
The owner of the call option only exercises if he/she finds it in
his/her interest
 Recall however that for each “long” side of the contract there
is a “short” side. If you sell the option, you will be required to
sell at $X per share when the option is exercised (which will
only occur when the price of the underlying security is greater
than $X)
 “Zero sum game”
 Types of Options

 American Put Option:

 Contract giving its owner the right to sell a given

number of shares (100) of a specific security at the
strike price (X) at any time prior to maturity (T)

 Again, if you sell this option, you must buy shares at

$X if the option is exercised
 Types of Options
 European Call and Put Options:
 Like American call and put options except that
exercise is only possible at expiration

 The geographical labeling is a misnomer. Most

options traded here and in Europe are American
options. Foreign currency options and some stock
index options traded on the CBOE are important
exceptions however. (The SP500 options contract is a
European option while the SP100 contract is
American.)
 Notation
 Co: Current price of a call option (per share).
 Po: Current price of a put option.
 X: Strike or exercise price.
 T: Expiration date.
 t: any time between issue date and maturity date
 So: Current price of the underlying security (stock).
 X < So: Call is in-the-money (put is out-of-the-money).
 X > So: Call is out-of-the-money (put is in-the-money).
 Notation
 Strike Price:
- Option contracts on equities are introduced with strike
prices in increments of $5 above and below the current
stock price ($10 increments may be used for stocks
selling for more than $100, and $2.50 for stocks trading
at less than $30)

- New contracts are introduced as the stock price

increases or decreases
 Notation
 Expiration Dates:
- Most Puts and calls traded on equity options have
maturities < 9 months. Options expire at the end of the
third Friday of the expiration month.
- Typically, a stock has option contracts with three
expiration dates (separated by three months)
- More heavily traded options have four expiration months
(nearest two months and the next two months in the normal
3-6-9 month cycle)
- For example, IBM in the beginning on January will have
January, February, April and July options traded
 Notation

 Expiration Dates:
- The most heavily traded options are the ones trading
near-the-money with the closest expiration date
- LEAPS (Long-term equity anticipation securities) are
long-term exchange traded options that last up to 3 years.
They are currently traded on indexes on the CBOE and
on individual stocks on various exchanges 
 Other Types of Options
 Warrants
- Call options issued by a firm
- Exercise requires the firm to issue new shares and
results in a cash flow to the firm
 Asian Options
- Payoffs depend on the average price of the
underlying asset during at least a portion of the life of
the option
 Other Types of Options
 Barrier Options
- Depend not only on the asset price at expiration, but also
on whether or not the asset price has crossed through
some barrier.
- A “down and out” option expires worthless if the asset
price falls below some level.
- A “down and in” option expires worthless unless the
asset does fall below some barrier al least once during the
life of the option.
 Other Types of Options
 Lookback Options
- Payoffs depend in part on the maximum or minimum
price during the life of the option
 Currency-Translated Options
- Either the asset price or exercise price is denominated in
a foreign currency
 Binary Options
- Provide a fixed payoff if the stock price meets some
condition (for example, if S > X, the option pays $1000)
 Equity Option Trading
 Puts and Calls on individual stocks and on stock indices
actively traded on CBOE and the International Securities
Exchange (an electronic market based in NY)
 Before 1973, no trading of standardized options in the U.S.
There was some trading of options on OTC market, with large
transaction costs and low trading volume
 Options trading dates back to the 17th century Holland, where
farmers purchased put options on tulip bulbs to reduce price
uncertainty
 Without a centralized agency to guarantee payment in the
event of exercise, hard to trade option contracts because of
solvency issues
 Equity Option Trading (cont.)
 CBOE started trading calls in 1973:
- Completely standardized option contracts
- Few (3 or 4) maturities
- No paper certificates (electronic book entries)
- Higher trading volumes and liquidity, lower
transaction costs
- All contracts are with the Option Clearing
Corporation. No risk of default (from perspective of
buyers)
-
 Adjustments
 Calls and Puts are not adjusted for cash dividends

 X is adjusted for stock splits

 Example: Stock has a 2-for-1 split:

- St (after split) = ½ St-1 (just before split)
- Call (X=$50) would split into two calls (X=$25)
 Basic Transactions in Calls
 Buyer purchases American call at time 0
 At any time t (0<t<T) the buyer can do:
- Exercise the call by paying 100(X) dollars. He then
receives 100 shares of stock worth 100 (St) dollars in
exchange
- Cancel the position by selling the call for 100 (Ct) dollars
- Hold on to the call
- The maximum loss is limited to the initial investment 100
(C0)
 Writer or seller of an American call option is obligated to deliver
100 shares of the underlying stock in exchange for 100 (X) dollars
 Basic Transactions in Calls
 At any time t (0<t<T) the writer can:
- Close out the position by buying a call for 100 (Ct) dollars
- Do nothing
- Maximum loss is unlimited, so margins must be posted to guarantee
payment in the event of an exercise
 Naked position in options refer to long or short positions in an option that are
not combined with a position in the underlying security
 Here, buying a call is “bullish” strategy, while buying a put is a “bearish”
strategy
 Although buying a call gives you unlimited upside gain, it is risky (You stand
to lose your initial investment)
 Options can be used by speculators as leveraged stock positions, but they can
also be used creatively to manage risk exposures as the following example
makes clear
 Basic Transactions in Calls
 EXAMPLE: Assume IBM currently sells for $70 and your analysis
indicates a significant increase in price. Of course, you cannot forecast
firm-specific shocks, and IBM could fall in price.
 Assume as well :
- The price of a 6 month call option with X = $70 currently sells
for $7
- The interest rate for the period is 3%
 What are the profits (returns) to the following three strategies for
investing $7,000 as a function of IBM’s stock price in 6 months?
A. Purchase 100 shares of IBM stock
B. Purchase 1000 call options w/ X = $70 (10 contracts)
C. Purchase 100 calls for $700. Invest remaining $6300 in T-Bills
($6300 * 11.03 = $6489)
Option Strategies: Protective Put at
Option Expiration
Covered Call Position at
Expiration
 Other Option Strategies
 Straddle: A long straddle is established by buying both a call and a put on a stock
with the same expiration date and strike price. This is a bet on higher volatility than
expected by the market
 Some Option Strategies (cont.)

 In Class Exercise:

What are the payoffs and profits to shorting a call and a

put?
 Other Strategies
Bull Spread

Bear Spread Butterfly Spread

 Put-Call Parity
 Until now, we have simply assumed the prices for calls and
puts
 As an introduction to the valuation of options, we consider the
relationship between the price of a European call and a European
put on a non-dividend paying stock
 Basic setup
- No transaction costs
- No taxes
- Ability to borrow and lend at the same (risk-free)
interest rate
 Put-Call Parity (cont.)
 Put-Call parity gives the following relation between the
price of a put and a call:
X
S 0  P0   C0
(1  r f ) T

 Recall that S0, P0 and C0 are the prices today of the stock,
put and call respectively
 You can think of the third term as the present value of the
strike price or, alternatively, an investment in a zero-
coupon risk-free bond that will grow in value to the strike
price at the expiration of the call and put options
 Put-Call Parity (cont.)
This relation can be demonstrated as follows. At expiration (at
time T), there are two possibilities: ST < X or ST > X, We can
value the portfolios from either side of the equality above as
follows:
Portfolio Value if ST  X Value if ST > X

S T + PT X ST
(put is in the money and worth (put is worthless)
X - S)

 
X ST
X
 CT (call is worthless) (call is in the money and
(1  rf )T
worth S – X)
 Put-Call Parity (cont.)
 Note that in either case, the two portfolios have equal value.
Therefore their prices today must be equal. If they are not it will be
possible to earn an arbitrage profit!
 This is accomplished by buying the portfolio that is undervalued
and financing this purchase by selling short the portfolio that is
overvalued. This will result in a positive cash flow today with no
future risk because the short and long positions will cancel each other
out at time T
 In class exercise: Suppose European put and calls exist on the same
stock, each with X = $75 and the same expiration date. The current
stock price is $68. The current price of the put is $6.50 higher than
that of the call, and a risk-free investment over the life of the options
will yield 3%. Devise a strategy that will earn risk-free arbitrage
profits.
 Put-Call Parity on Dividend Paying
Stocks
 The more general form in the case where the stock pays a
known dividend over the life of the options is given as follows:
Dividend X
S0   P0   C0
(1  r f ) T
(1  r f ) T

where the last term is the present value of dividends to be

paid during the life of the option

Note that we have reduced the stock price by the present value
of the dividend
 The No-Arbitrage Principle and
Boundaries on Option Prices
 Consider a call option that pays no dividends
1) The value of the call cannot be negative -- This is
straightforward since the holder of the option will only
exercise it if it is in-the-money.
2) C0  S0 -- No one would pay more than $60 for the right
to buy a stock currently worth $60!
3) C0  S0 - X/(1 + rf) -- Consider two portfolios:
A) A call option on one share of stock
B) One share of stock and borrow X/(1 + rf) (the PV of
the strike price)
 The No-Arbitrage Principle and
Boundaries on Option Prices

At expiration:

  IF ST  X IF ST < X

Portfolio A S-X0 0

Portfolio B S - X (payback S - X (payback

loan)  0 loan) < 0
 The No-Arbitrage Principle and
Boundaries on Option Prices
Although we have placed no-arbitrage bounds on the price of a
call, we obviously need more precision. On to option pricing!